I don’t follow investor newsrags very closely, having no money to invest, but BlogHouston has the scoop on one of the two major bond rating agencies revising the City of Houston’s credit outlook downwards. Unsurprisingly, Mayor White took advantage of this to announce that he never met a tax hike he didn’t like. Oops, I mean criticise Proposition 2.

I’m of two minds on the whole mess. In general, though I’ve opposed it in the past, I think the revenue cap is probably not a bad idea, since it protects the average citizen from the effects of the pension mess. (I’m still leery of joining in to the contributory plan, but I’m fairly sure if I don’t, I’ll get totally screwed as a “free rider.” As if.) However, the mayor’s got a point–Proposition 2 is far too restrictive because we can’t adjust for things like Katrina/Rita. We’re not getting all that money back from the feds, people. And if there’s one thing that should be evident from recent history, it’s that simplistic referrendums tend to backfire. Goverment is a hugely complicated beast; that’s why we elect people to handle it for us.

As for the downgrade, BlogHouston has a long quote at the link above, but simplified, it comes down to this: the city doesn’t actually pay for capital improvements from tax revenue. (Few governments do.) Instead, it sells bonds (borrows money) to pay for the improvements, then pays off the debt over a term, usualy 10-20 years. The rate of interest paid on these bonds depends partly on the market, and partly on their rating. And the rating is determined by two (Edit: 3) major agencies; it is essentially their estimation whether anyone who buys a bond (i.e.: loans money to the city) will get their investment back.

Now this paragraph is strictly from memory, not research, so don’t take it as the 100% accurate gospel. IIRC, Fitch is the more conservative of the two, Moody’s is better known, and slightly more lenient towards stressed finances. They each have rating systems based on the alphabet, roughly (worst to best) D, C, B, A, AA, AAA, AAAA. They’re not exactly the same; I think Moody’s runs C-AAAA, and Fitch is D-AAA (really shaky on that, maybe a reader knows and can contribute?) and there’s + and – modifiers. But it’s not as simple as saying “the city has a rating of ‘x’. The city is given a rating for each category of bond that it issues. Then there is the rating outlook, which is a general prediction on whether things are expected to get better or worse.

I seem to recall that the City was downgraded from AAA to AA sometime around 2002-4 by Fitch’s, but again, that’s just plucked from memory. (See Update, below). Now I see we are at AA-. But the nature of the recent change is that the Rating Outlook, which was formerly Stable has now been revised to Negative. In short, Fitch thinks things are going to get worse. Which means that it will cost more for the city to borrow money, since the only way to get people to take the risk of lending it is to offer higher returns. Why did Fitch take this action?

Primarily (and exactly as predicted) it was due to the passage of Proposition 2.

The change in Rating Outlook to Negative reflects increased uncertainty in general fund operations in light of a summary judgment by a district court judge who upheld the enforceability of one of two revenue limitations measure recently approved by voters. Fitch typically views revenue limitations negatively given that they restrict financial maneuverability. The all-encompassing nature of one of the two propositions (Proposition 2) is cause for additional concern, and Fitch considers its possible implementation as a potential challenge to the city’s credit quality, given ongoing and future spending pressures.

In short, folks, we did it to ourselves, and we were warned it would happen.

There is more to worry about though. In Houston’s case, not only are we paying for the future pension obligations through borrowed money, but we are paying the current dues by borrowing money. This is akin to contributing to your 401(k) by charging it to your credit card. Needless to say, Fitch’s is not impressed with this funding technique, especially considering that it recognizes that the changes made in 2004 only bought the city some time, but did not solve the problem.

In addition, Fitch views the city’s debt financing of a portion of the city’s annual contribution to both the municipal and police pension systems as an indication of financial stress.

That’s putting it mildly. However, not all the news is bad:

General fund operations have reported sizeable surpluses in two of the past three fiscal years, and reserves have increased as a result. Fiscal 2005 ended with net income of $34.4 million, and the unreserved fund balance of $142.7 million, or 9.3% of spending and transfers out, was up sharply from the prior year. Finance department projections for fiscal 2006 year-end anticipate an increase in operating reserves of at least $4 million. Liquidity levels also have improved markedly over the past three fiscal years; the fiscal 2005 general fund cash and investments total was $111.7 million, compared to $27.7 million in fiscal 2002.

To sum up the entire article: the economy is improving and the city’s current bank balance with it, but even that isn’t enough to outweigh the long term implications of the city’s pension headaches and revenue limits.

Update: Three agencies, not two. Forgot Standard and Poor’s. The city’s ratings by each agency as reported in the CAFR for the year ending June 30, 2003 was:

Source: FY2003 CAFR

Next year, the ratings changed to:

Source: FY2004 CAFR